Volatility is back, with the U.S. equity market suffering a few tough weeks reminiscent of the dramatic action in 2020. Since their respective peaks on February 12, the S&P 500 Index has declined -5%, and the tech-heavy NASDAQ -10%. There is no shortage of good reasons for the market to sell off. Lofty valuations, speculative trading, legislative gridlock, and persistent COVID issues are a few good ones. Yet, in our view there is one reason above all others for the market’s recent weakness – a spike in interest rates and growing signs of inflation. Living through a market correction is never easy, but we see a silver lining here.
Before defining the silver lining, let me help you to understand the relationship between interest rates and stock valuations. When you buy a stock, you are paying cash today for the expectation of higher cash inflows (sales, earnings) in the future. You then “discount” those future inflows into today’s dollars. All else being equal, the higher the discount rate the less valuable the stock. Higher rates erode the value of future cash flows, but much more so for growth companies than for more mature businesses because growth firms expect to see a large share of their profits come farther down the line – which may explain why the recent correction has been so cruel to the high-flying stocks that appear to be trading well above intrinsic value.
Another linkage between interest rates and stock valuations has to do with simple supply and demand. When fixed income investments offer lower returns it logically stimulates more demand for equities, where higher returns can be found. In contrast, when fixed income provides higher yields, it reduces the demand for equities because they in fact become less competitive.
What might be causing rates to move up at this time? According to Credit Suisse chief U.S. stock strategist Jonathan Golub, the economy this year could “run hotter than at any time in the past 35 years”. With the Democrats at the helm, the odds of additional fiscal stimulus have increased, which could spur stronger economic growth. Also, uncharacteristic of a recession, savings rates have increased, leaving many Americans with dry powder once the pandemic eases. In fact, some estimates indicate that Americans have saved more than $1 trillion during the pandemic. It seems likely that there is significant pent-up demand for “normal” activities that have been unavailable because of COVID, including things like travel, movies, dining out, and entertainment. This spending surge could prompt stronger economic growth as well as potential inflation for some goods and services. The Fed has signaled that it is willing to tolerate higher inflation for a time following a period of low inflation. Since inflation is a key component of interest rates, if the Fed is willing to let inflation run a little higher than market participants are accustomed too, higher interest rates will follow.
Of course, this is all a matter of degree. Although interest rates have moved higher, they are not high. The yield on the 10-year Treasury bond sits at an accommodative 1.55% – well below its 50-year average yield of roughly 4.25%. But sustained higher interest rates would remove a stimulus that the market has come to expect, and regime change is never smooth. Our view is that investors deserve a higher return on “risk free” assets, and that a more competitive alternative to stocks will serve to limit the asset bubbles that have plagued the markets in recent decades.
Getting back to the silver lining, we believe that leading economic indicators are indeed improving and higher interest rates is a welcome consequence. In terms of how this informs our investment outlook, we see owning cyclical or “value” stocks as a prudent strategy to capitalize on a global recovery. Our attention has been on financial, industrial, basic material, and small capitalization stocks, all of which should benefit from: increased onshoring of businesses back from overseas, the possibility for a genuine commitment to infrastructure spending, and momentum in the industrial side of sustainable and renewable products and systems. Secular growth stocks have led the stock market for nearly twelve years. A broadening of strength into the value side of the market will certainly open more opportunity and choice for the tactical investor.